Emergency funds have always been essential but the second and a deadlier wave of the Covid-19 pandemic has prioritized its need like never before. Unprecedented medical exigencies across the country have brought to the forefront the importance of having liquid money to ensure health and safety during a sudden need not just for one but for the entire family. Emergencies come unannounced and so it is crucial to be financially ready to deal with the challenges they pose.
An emergency fund is that cash corpus that you build to prepare yourself to deal with unexpected situations such as a job loss or medical emergencies. An emergency fund is created anticipating the financial crunch that you may face during any unexpected event of your life.
How Much of Emergency Fund One Needs
An emergency fund should ideally be good enough to meet your three to six months of expenses as per your income. However, looking at the financial challenges, the Covid-19 pandemic has thrown, the bigger your emergency fund, the better it is. Do remember that making an emergency fund is not a one-time exercise and it should be periodically topped-up or replenished every time it is used. You should review your emergency once every year and revise it as per changes in your income, lifestyle and situations.
How To Build An Emergency Fund?
An emergency fund cannot be built overnight. It requires discipline and commitment. While there are many ways to build an emergency fund, you should go for a risk-free option which provides easy liquidity and is accessible. You should set aside a fixed amount every month in your fund till you reach the optimum level of savings you need.
Where To Invest?
Fixed deposits and savings bank accounts are amongst the popular ways to build an emergency reserve. Investing in a liquid mutual fund is another way to build a strong emergency corpus. While choosing your options, compare them based upon your horizon, real rate of return and taxation.
Let us understand them in detail to know which caters to our needs.
Savings Bank Account
A savings bank account is one of the most convenient and risk-free ways to build an emergency fund. It provides easy liquidity during a financial crunch so having some funds saved in a savings account makes sense. You can reach out to your savings account anytime from anywhere to withdraw cash. Choose a reputed bank offering a good rate of interest with easy-to-manage minimum balance requirements. The interest rates offered range from 2% to 7% depending on the bank.
Fixed deposits are another preferred and safe way to build an emergency reserve. In a fixed deposit, you do a lump sum investment with a bank or company for a fixed tenure and earn interest on the investment either through the tenure or at the end of it. So when you invest a lump sum amount in an FD, you will not only get the amount invested but also the interest earned on it. The return in this investment is based on the tenure chosen and the interest rate ranges from 2% to 7% p.a.
FDs are a better way than savings fund for creating an emergency fund because of the higher interest payment which helps your money grow faster. You could also opt for a sweep-in FD with your bank which lets your bank automatically park your surplus funds from the savings account into an FD earning a higher rate of return. Remember that while FDs can be prematurely liquidated, such an act will lead to an interest penalty – typically one percent of the interest.
Liquid funds are the safest debt mutual fund schemes that invest your funds in short-term money market instruments such as treasury bills and commercial papers with maturity periods of up to 91 days. Liquid funds provide easy liquidity as there is no entry or exit loads. Your investment can be liquidated within a day of your request. Unlike FDs,liquid funds don’t come with a lock-in period but their returns similar to bank FDs. Their returns mimic those of fixed deposits but often tend to be 50 to 100 basis points higher than FDs. Since they are tax-efficient, your returns are taxed only on redemption, which makes your post-tax returns from liquid funds higher than those from FDs in the long run.
You can also choose a recurring deposit (RD) to create an emergency fund. A set amount can be fixed by you to be deducted every month for an RD account that earns interest similar to an FD. When you have saved enough money for an emergency fund, the wise thing to do would be to diversify into different but safe avenues that provide easy access whenever you need funds.
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